GLNCY Glencore Plc (PK)

By Carolyn Cui 

A broad selloff that has rattled emerging markets is showing signs of spreading.

The root of investors' anxiety lies in China's economy, which in 2015 is on track to grow at its slowest annual rate in six years. Another major worry is the fallout from higher U.S. rates, which many Federal Reserve officials say are likely to arrive later this year.

The slowdown in China, the world's biggest importer of many raw materials, has pummeled commodity prices and weighed on global trade, two factors that are putting other developing nations under strain.

Even as the problems in China reverberated across the globe in the third quarter, many fund managers remained confident that markets in the U.S. and other developed countries would be able to withstand the headwinds without too much damage. That increasingly is coming under question as the global-growth outlook continues to deteriorate.

The plunge in the share price of commodity-trading firm Glencore PLC and a rise in corporate-default rates world-wide could signal a new phase in a downturn that has rocked financial markets since midsummer, some investors say.

The head of the International Monetary Fund on Wednesday said the organization would again downgrade its estimate for global growth.

"We're focusing on China and emerging markets now as the biggest risk to the U.S. economy and global markets," said David Spika, global investment strategist at GuideStone Capital, which oversees $10.7 billion in assets. "If we were to see a bleed into the U.S. economy," the emerging-market slowdown would be the cause, he added.

Global investors pulled $40 billion from emerging-market stocks and bonds in the third quarter, according to estimates from the Institute of International Finance. That is the biggest outflow since the fourth quarter of 2008, during the height of the financial crisis.

In the third quarter, the MSCI Emerging Markets Index tumbled 20% through Tuesday, its worst quarterly performance since the third quarter of 2011.

The MSCI World Index, which tracks developed-country stocks, fell 9.3% in the period. The Dow Jones Industrial Average declined was down 8.9% for the quarter through Tuesday.

The J.P. Morgan GBI-EM Global Diversified Index, a benchmark for emerging-market bonds issued in local currencies, posted a return of minus 12% over the past three months, the worst quarter since the index was launched in 2003.

"We came through a period where the consensus was far too optimistic on the growth outlook in emerging markets," said Neil Shearing, chief emerging-markets economist at Capital Economics.

Mr. Shearing added that he thinks investor sentiment has become too negative because fund managers are lumping relatively healthy emerging markets such as Mexico and Poland in with more troubled economies like Brazil and Turkey.

A full-blown crisis like the one that hit developing nations in the late 1990s appears unlikely, many economists say, due to the broad adoption of free-floating currencies and the accumulation of large foreign-exchange reserves.

China tapped its war chest to stem the decline of the yuan, whose Aug. 11 devaluation sparked a bout of turmoil in financial markets. The yuan has clawed back more than half of its losses against the dollar since then, which some analysts say will keep the selloff in emerging markets from deepening significantly in the short term.

But the damage is already substantial. While a weaker currency tends to boost the competitiveness of a country's export sector, it has made it more expensive for borrowers in these countries to service and pay back dollar-denominated debt. It also stokes inflation, reducing consumers' purchasing power in these countries.Ã

Among the worst-performing currencies in the quarter through Tuesday were the Brazilian real, which fell 22% against the dollar; the South African rand, which weakened 12% and the Malaysian ringgit, which slid 14%.

These countries are the biggest commodity suppliers to China, and are suffering from a double whammy of a downbeat demand outlook and lower commodity prices. The S&P GSCI, an index that tracks a basket of 24 commodities, in late August hit its lowest in more than six years and remains near that level.

One of the biggest casualties of low commodity prices is Glencore, whose share price collapsed on Monday--before rebounding on Tuesday--amid concerns about the company's credit rating and its massive debt load.

Glencore's woes woke investors up to the risks that the rout in emerging markets and commodities pose to the global financial system. Glencore says it maintains access to its lines of credit thanks to its strong relationship with its banks.

In a September report, the Bank for International Settlements warned of a looming banking crisis as a result of rapid credit growth in some emerging markets. China boasts the highest ratio of private-sector credit to gross domestic product, standing at 25%, followed by 17% in Turkey and 16% in Brazil. Slowing growth could impair these companies' ability to service their debt, driving up the bad loans at the banking sector in these countries.

Historically, a country with a ratio above 10% has a two-thirds chance of "serious banking strains" occurring within three years, said the BIS, noting "early warning indicators of banking stress pointed to risks arising from strong credit growth."

The size of the emerging-market nonfinancial corporate bond market has doubled since 2009 to a record level of more than $2.4 trillion in 2014, according to the IIF.

In Brazil, 10 companies have defaulted on their debt this year, compared with six for all of 2014, according to Moody's Investors Service. Brazil is struggling with a deep recession, high inflation and a widening scandal at its state-run oil company.

In Latin America, the corporate default rate hit 4.2% in the 12 months ended June, up from 3.1% a year ago, according to Moody's.

If the Fed raises the U.S. short-term benchmark interest rate from near zero in the fourth quarter, as many investors expect, the action could put more upward pressure on borrowing costs in emerging markets as well, likely pushing more borrowers into default.

Heavy corporate borrowing was just one reason why economists and policy makers are becoming more worried about China these days.

Shuang Ding, head of Greater China economic research at Standard Chartered Bank, said he is upbeat on the Chinese government's ability to boost growth in the short term given its resources and policy room, but he has doubts about the country's long-term growth prospects. If the government continues to use credit and stimulus to bolster growth, "that will postpone the fiscal adjustments that are needed for the economy" and cause more problems down the road, he said.

"The world is looking to China more and more every day," said Jordi Visser, chief investment officer at Weiss Multi-Strategy Advisers LLC, a hedge fund with $7.2 billion in assets.

Mr. Visser drew parallels between China's August currency devaluations and the U.S. government's decision to allow Lehman Bros. go under in September 2008, which sent shock waves around the world.

"We all underappreciated the globalization that has occurred and how much dependent we're on each other more than we have been in the past," Mr. Visser said.

(END) Dow Jones Newswires

September 30, 2015 15:21 ET (19:21 GMT)

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